ETFs under the spotlight as shadow falls across UBS's Delta One operation

Reverting to what Swiss banks do best, UBS was keeping distinctly private
about the activities of its rogue trader on Thursday. But behind the scenes,
the bank's so-called Delta One operations came under intense scrutiny.

ETFs were designed as inoffensive tracker funds of global indices – a means for investors to buy exposure to the FTSE 100, for example, rather than just individual stocksPhoto: AFP

Traders were questioned, their systems swept and some telephones were removed, according to insiders. They were not alone. Across the City the corresponding desks of most of the other banks found themselves the subject of unscheduled attention from compliance, too.

There were plenty of grumbles. Despite rapid growth, these operations, which are dominated by the sale of complex exchange-traded funds (ETFs) and swaps, are low profile compared with flashier divisions. One trader at a rival bank said: "Look, fraud is fraud. These things happen, it doesn't mean the whole system is rotten."

Maybe not. But unfortunately for Delta One traders, the $2bn (£1.3bn) black hole at UBS has emerged at the very moment when regulators around the world suspect that ETFs could be the cause of a fresh financial crisis.

Just on Monday, it was reported that America's Securities and Exchange Commission (SEC) had launched a probe into whether leveraged ETFs had exacerbated the alarming market volatility over the summer. The SEC and other state regulators in the US have issued alerts over the past two years about the dangers of ETFs for retail investors.

In Britain, the Bank of England warned in its June Financial Stability Report that ETFs were not suitable for all investors. In July the Serious Fraud Office put ETFs on its list of "potential risks". Famously, Jerome Kerviel, a trader at Societe Generale's Delta One division, blew a €4.9bn hole in the French bank.

There have been concerns about specific types of ETFs. Last year The Telegraph revealed that the Financial Services Authority had been warned that a new range of physically-backed commodity ETFs would distort the world's metal markets and cause the "next financial bubble".

Little wonder that UBS's admission on Thursday caused panic – particularly coming on the third anniversary of the collapse of Lehman Brothers.

In theory at least, the fears seem overblown. ETFs were designed as inoffensive tracker funds of global indices – a means for investors to buy exposure to the FTSE100, for example, rather than just individual stocks. Taken from the Greek description of the rate of change, Delta One literally describes this market mirror.

In practice, rather than going to the market, clients can ring up an investment bank and order a tailor-made ETF. The banker's job is then to go and buy the "underlying" assets – which may be a future or option or physical share. As one trader said: "The bank then runs the underlying assets as a kind of portfolio. Instead of being long Vodafone and short BT, he'll be long a basket of FTSE100 and short a basket of S&P. The portfolio can be leveraged up and reinvested, too."

For clients, ETFs have exploded in popularity because they are fast to buy and cheap. From a standing start in 1990, ETFs grew steadily – the market was around $104.8bn in 2001 – but ballooned to $1.44 trillion by June 2011. There are now a whole range of funds in fixed income, commodities and currencies, some of which are highly geared. Of almost 3,000 funds, the clearest division is between physical ETFs and synthetic funds, in which the banker does not buy the physical security but enters into a contract with another bank that has exposure to it.

Dr Richard Reid at the International Centre for Financial Regulation said: "These synthetic ETFs are much more complex and may also represent liquidity risks to bank funding. They raise memories of the sub-prime crisis, packaging of mortgage bonds and a basically good idea turning into a poorly understood and monitored innovation."

Even so regulators have failed to agreed on a specific concern about ETFs.

The growth of the market was the first alarm bell. The Bank of England said that the complexity, interconnectedness and opacity of the market spelt potential danger. In its report, the Bank said it found physical ETFs to be "relatively simple products" but that they had hidden counterparty risks. In Europe, the synthetic market is bigger and worries range from counterparty risks to different collateral practices between the banks.

One trader said: "When a bank sells an ETF in, say, the French CAC, instead of buying the corresponding index to cover its own risk other collateral can be used that has nothing to do with the CAC, it could be Greek for all we know. In this way, banks could look like they're holding equivalent collateral when actually it's just a whole load of junk assets. Dangers can build up."

In its report the Bank of England had a different concern on collateral saying that the "[investment] bank might have incentives to use the synthetic ETF structure as a source of collateralised borrowing to fund illiquid portfolios".

Proponents of ETFs argue that the fears are overblown. One said: "The FSA has long lists of ETFs and details of the risks. Synthetic instruments are well understood, too."

Even so, at UBS at least, Delta One activities were complex enough for a 31 year-old to allegedly hide a $2bn loss, which means more regulation is almost certainly on the way.